November 20, 2013

The overall state of the economy remains strong despite lower metal prices and recent market turbulence. The economy is still operating somewhat near potential and continues to be one of the most dynamic in the region. However, the pace of growth slowed in 2013 given external shocks. Headline inflation increased due to a combination of supply shocks and exchange rate “pass-through” effects. Against this background, the Central Bank (BCRP) started to ease monetary policy to support activity and allowed greater exchange rate flexibility to protect the economy from external shocks. Fiscal policy provided a substantial positive impulse, and will continue to be supportive of growth in 2014. Looking ahead, the economy is expected to rebound in 2014 as exports and business confidence strengthened, and as large infrastructure and mining projects come on stream. If the external environment deteriorates further, Peru has buffers to limit the negative effect of an external shock on output and income. Implementing the structural reform agenda will be key to enhancing potential growth.

A. Context, Outlook and Risks

1. Following a decade of record high rates of economic expansion, the growth momentum slowed in 2013 mostly due to adverse external conditions.

• Economic activity. Following an expansion of 6⅓ percent in 2012, economic growth slowed to about 5 percent in the first three quarters of 2013 (yoy) due to a moderation in private investment and a decline in exports. Uncertainty increased after the fall in metal prices, and business and consumer confidence dropped. The turbulence in capital markets generated by the U.S. Federal Reserve’s announcement of a possible “tapering” of asset purchases also added to the existing uncertainty. With confidence improving recently, the recovery will be gradual. Despite the economic deceleration, the economy continues to operate somewhat near potential, and real GDP growth is expected to decelerate to around 5 percent in 2013.

• Inflation. Headline inflation picked up in recent months, mostly due to supply shocks, and the “pass- through” effect of the depreciation of the exchange rate, standing slightly above the target band of 1–3 percent as of October 2013. However, non-food/non-fuel inflation is well within the inflation target range and inflationary expectations remain well-anchored (although above the mid-point of the target range). Headline inflation is expected to reach 3 percent by end-2013.

• External conditions. While the external position deteriorated due to lower export prices, lower export demand, and higher interest rates abroad, Peru’s sovereign credit rating was recently upgraded by Standard and Poor’s and Fitch to BBB+ based on the strength of fundamentals, solid fiscal indicators and large buffers to counter shocks (the second best rating in Latin America). The current account is expected to reach about 5 percent of GDP in 2013, but should be easily financed by private capital inflows, mainly foreign direct investment (FDI).

2. Macroeconomic policies were geared towards smoothly allowing the economy to adjust to the deteriorating external conditions while supporting the economy.

• Fiscal policy was adequately accommodating. The fiscal position weakened in 2013 on account of: (i) an increase in primary spending to achieve social inclusion goals and higher wages following the civil service reform; (ii) a continued effort to increase capital spending; and (iii) a reduction in mining related revenues following a fall in metal prices. The overall fiscal balance will fall from a surplus of 2¼ percent of GDP in 2012 to a surplus of about ½ percent of GDP in 2013. In the absence of this fiscal easing in 2013, the economic slowdown would have been more pronounced.

• Monetary policy was relaxed on evidence of a continued slowdown in economic activity. After 2½ years of keeping the policy rate unchanged at 4¼ percent, BCRP reduced its policy rate by ¼ of a point in November 2013, citing slower domestic and global growth. The cut was intended to be preventive and consistent with inflation objectives. Earlier in the year, hikes in average reserve requirements (RR) through April 2013 helped moderate private credit growth from about 15½ percent at end-2012 (yoy) to about 13 percent by end-September 2013 (yoy). However, financial turbulence in May 2013 and subsequent increase in U.S. long-term interest rates required an unwinding of macro-prudential measures to ease liquidity flows and to reduce dollarization of credit. BCRP reduced reserve requirements on domestic liabilities and announced higher reserve requirements on foreign currency liabilities if dollar credit expanded above established limits.

• The exchange rate moved in line with fundamentals. After a long streak of intervention through April 2013 to prevent an undue volatility of the nuevo sol, the BCRP did not intervene for several months and then started to sell foreign exchange in July 2013 to limit the volatility resulting from the financial turbulence. In these conditions, the nuevo sol depreciated about 8½ percent in nominal terms in the first ten months of 2013.

• The financial sector remains solid. The banking system remains well-capitalized, sound, and profitable. However, the banking system remains vulnerable to exchange rate fluctuations given the high, but declining, credit and deposit dollarization of around 40 percent. To moderate risks, the BCRP and the banking supervisor (SBS) employed macro-prudential policies to limit the expansion of U.S. dollar loans and encouraged their substitution by fostering credits in nuevos soles. While non-banks’ exposure to foreign exchange risk is limited, their financial health has worsened somewhat recently, reflecting softer economic conditions.

3. The outlook for the Peruvian economy remains favorable. Real GDP growth should rebound to 5½ percent in 2104 on the back of a rebound in exports as large mining projects are coming on stream and large infrastructure projects in the pipeline. Inflation is expected to converge towards the mid-point of the target range as supply shocks unwind. The widening current account deficit is expected to reverse over the medium term on the back of projected increases in mining exports and normalization of global conditions.

4. Going forward, there are risks to the outlook in both directions. On the domestic side there are risks on the upside, whereas external risks are tilted to the downside, but current buffers are sufficient to address possible short-term shocks.

• Domestic upside risks. The pace of the recovery could be stronger than envisaged due to a variety of factors, including: (i) the greater speed of operating at full capacity large mining projects coming on stream; (ii) the ability to implement rapidly large infrastructure projects in the pipeline; (iii) the effectiveness of the investor facilitator office in handling a larger volume of cases; and (iv) the faster adoption of the authorities’ reform agenda. Also, it is possible that with relatively softer economic conditions, the recent macroeconomic stimulus could have a faster effect on the economy.

• External downside risks. A hard landing in China (one of Peru’s largest export markets) could lead to a drop in metal prices, and thereby exports and growth in Peru. In this case, the exchange rate should work as a shock absorber, although there are risks given the dollarization of the financial system. Monetary and macro-prudential policies could be relaxed to ease the adjustment cost and to support economic activity. If the economic slowdown is too pronounced, a temporary fiscal impulse could be used. Another risk would be the disorderly withdrawal of monetary stimulus in the U.S., which could disrupt global financial flows and lead to sudden stops and reversal of some capital flows to Peru. As done in previous occasions, this would require the central bank to deploy resolute actions to maintain confidence and ensure an orderly functioning of markets. As in the case of the Lehman crisis, exchange rate flexibility and the use of reserves and liquidity buffers, as well as conducting repo operations and dollar swap auctions would help ensure liquidity in the financial system. In the event of a sudden capital flow reversal that creates a credit crunch, a temporary fiscal stimulus might be appropriate.

B. Near-Term Policy Challenges

5. The current policy mix is appropriate to maintain macroeconomic stability.

• Fiscal policy. The 2014 budget sent to Congress envisages a zero overall fiscal balance. By applying historic rates of budget execution, the overall balance should yield a small surplus of about ⅓ percent of GDP for 2014. This reduction in the fiscal surplus (compared to a surplus of about ½ percent of GDP in 2013), adjusted for the economic cycle and fluctuations in commodity prices entails a small fiscal impulse of about ⅓ percent of GDP in 2014, which is counter-cyclical and appropriate given the soft economic conditions at present.

• Monetary policy. The recent reduction in the policy rate was undertaken against the background of a decelerating economy and declining business and consumer confidence, which was counter-cyclical and appropriate. However, BCRP will need to continue to be vigilant and implement policies flexibly in 2014 considering current and expected conditions.

• Exchange rate policy. The exchange rate is flexible and broadly in line with fundamentals. The current account deficit has widened recently due to a fall in metals prices. The exchange rate should continue to be driven by fundamentals in the medium to long terms, while limited foreign exchange intervention could be necessary to ensure a proper functioning of the foreign exchange market and to contain excessive risks to the balance sheets in a still dollarized economy. Facing a reduction in capital inflows, such interventions are likely to be sales of foreign exchange in the short run, and thus would need to continue to be sterilized to prevent a credit crunch and unnecessary upward pressure in the interbank rate. Exchange rate flexibility creates incentives for the deepening of the forwards (and other derivatives) market as the private sector internalizes exchange rate risks.

• Macro-prudential measures. Macro-prudential policies should continue to be well targeted to reduce vulnerabilities. In addition to the recent macro-prudential measures to deter the growth of dollar loans, there is a need for measures to discourage un-hedged foreign exchange exposures. The high spread between reserve requirements on dollar deposits and that on local currency deposits needs at least to be maintained, if not increased, to discourage dollarization. While the overall financial system remains healthy and strong, the recent deterioration of financial soundness indicators for non-bank deposit-taking institutions warrants closer monitoring and supervision as well as pre-emptive measures.

C. Medium-Term Policies to Preserve Strong Economic Growth

6. Structural policies need to be swiftly implemented to strengthen growth prospects over the medium term. Lower metal prices may slow mining related capital inflows leading to lower capital accumulation and potential growth, and should be compensated with additional reforms to prevent potential growth from falling. Against this background, delays in implementing the reform agenda may lead to a downward pressure in the potential growth of the economy in the short-term. The mission agrees with the authorities' efforts to implement structural policies to strength potential growth prospects, mainly in a context of lower metal prices over the medium term.

7. Peru has been taking important strides to increase the country’s growth potential and ensure inclusive growth. Decisive implementation of the authorities’ reform agenda is needed to prevent a fall in growth potential, and to reduce poverty.

• Investment facilitators. Progress has been made in enhancing competitiveness by reducing barriers to investment and increasing the efficiency and effectiveness of public management. A special team was appointed within the Ministry of Economy and Finance to identify and reduce barriers to investment projects, with the aim to speed them up. Legislation and other norms have been approved for this purpose. Over 50 projects accounting for around 10 percent of GDP have been identified, and are under close monitoring to ensure completion. Furthermore, the goal is to consolidate this into a permanent unit to accompany and facilitate completion of investment projects in the future. 

• Labor reform. Further progress is warranted to boost productivity through increasing labor market flexibility, where reforms are on-going, including through introducing measures to reduce non-salary costs, upgrading human capital through training and increasing availability of student credit, and strengthening institutions.

• Capital markets. Easing access to alternative sources of funding through further capital market reforms would facilitate effective allocation of savings in the economy. On the supply side the Securities Market Promotion Law includes two important regimes to facilitate the development of the securities market: the exceptional public-private regime for institutional investors and the special regime for medium enterprises, which gives more flexibility to the Alternative Securities Market. On the demand side, with the Private Pension Funds Reform the authorization process for the Pension Funds became more flexible and has increased the investment limits for alternative instruments, including investment in private funds, which represent the main vehicles to invest in infrastructure projects and companies that are not register in the Peruvian stock market.

• Production boost. A number of initiatives were taken to strengthen production and facilitate commerce, including the introduction of credit insurance for exports for small and medium-size enterprises and establishment of the fund for science, innovation and technology. Reforms are also targeted at improving the national system of quality, and spurring the development of the logistical services in the transportation sector.

• Legislation. Important laws have been passed as well, and aim, among other, at generating greater public access and savings through a private pension system, and enhancing the quality of public service through the civil service reform.

• Inclusive growth. As part of the national strategy for inclusive growth, social agenda was pursued through broadening the existing projects (Juntos, Cuna Mas, and Qali Warma) and advancing new initiatives to increase transparency, such as designing a registry of beneficiaries.

8. The recently approved Fiscal Responsibility Law introduces a fiscal anchor that addresses challenges of cyclicality and volatility associated with non-renewable wealth. The new fiscal framework is based on the structural fiscal balance and introduces more predictability and stability to public spending, reduces pro-cyclicality, increases coverage and simplifies fiscal rules at sub-national level. The structural fiscal anchor decouples the fiscal stance from short-term variations in commodity prices, and is transparent. The new framework also strengthens accountability by introducing a fiscal council; and delineates better the relationship and fiscal practices between the national and sub-national levels. When integrating the framework into the budget process, it would now be important to take into account fiscal risks associated with contingent liabilities and natural disasters, as well as the need to close the infrastructure and social gaps over time. A strong political commitment as well as a steady implementation of a fiscal rule is equally important. The design of the new fiscal framework involved the participation of the IMF, the BCRP and independent experts to provide more transparency and commitment to the process.

9. With tax revenue under pressure from the fall in revenue from metals, achieving ambitious tax targets would require more resolute efforts. The institutional framework and the comprehensive overhaul of the organization of SUNAT were approved last year, and good progress was made in doubling capacity, coverage and control process, which is evident by the good performance of income and sales taxes. Work is on-going in improving the system of risk controls, especially in customs, better diagnosing the system’s bottlenecks and improving information systems. Despite this progress, additional efforts are needed to continue improving tax collections, reduce the high level of informality and tax evasion, and decrease exemptions which amount to about 2-3 percent of GDP.

10. Further strengthening of macro-prudential policies and deepening of reforms to enhance the functioning of the capital markets are welcome. Going forward, it would be important to contain the buildup of systemic risks through monitoring corporate and household balance sheets, and formalizing the financial stability framework.

The mission would like to thank the authorities and senior officials at the Central Bank, Ministry of Economy and Finance, Superintendency of Banks, and other ministries and public and private agencies, for their cooperation and frank and cordial discussions.